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Abstract

The authors use a panel data regression model to examine the effects of main monetary policy instruments on commercial bank risks in China from 1998 to 2011. The interest rate has a positive effect on bank risk while the interest rate margin, the reserve requirement ratio and open market operation have a negative effect. Among the three monetary policy instruments, the reserve requirement ratio has the greatest effect on bank risk, the interest rate (the interest rate margin) the second largest and the open market operation the weakest. Their findings provide guidance to the monetary authority and regulatory authorities in monetary policy and banking regulation in China.

1. Introduction

After the burst of the dotcom bubble, many central banks have adopted a low interest rate regime over an extended period to ward off recession. Persistently low real interest rates can fueled a boom in asset prices and securitized credit and lead financial institutions to take on increasing risk (Nicolò et al., 2010). It is likely that banks’ risks will be increased. Although it is difficult to state that monetary policy has been the main cause of the 2008 international financial crisis, it could have contributed to its build-up. Thus, how monetary policy affects bank risks has become a hot issue and a focal point of the debate in both academic circle and practice circle, especially after the 2008 international financial crisis (Ma & Sun, 2010; Chang, 2010).

The theoretical research in the literature suggests several channels that monetary policy (mainly interest rate) affects bank risks. First, interest rate policy of the central bank affects the bank's risks through asset valuation, business income, and cash flows, and the interest margin (Adrian & Shin, 2009; Borio & Zhu, 2008). Second, monetary policy affects bank risks through portfolio reallocation and risk transfer. As a result, the risk of the bank's investment portfolio and asset pricing will be affected. More importantly, the effect of monetary policy changes on bank risks may not be uniform across time, banking systems, or individual banks (Nicolò et al., 2010).

The empirical research shows some conflicting findings. First, loose monetary policy leads to an increase in bank risk and tight monetary policy can prevent the accumulation of bank risk (Angela & Peydró, 2010; Ioannidou et al., 2009; Delis & Kouretas, 2011; Yu & He, 2011),while others (Lucchetta, 2007; Tan & Su, 2011) indicate that loose monetary policy may reduce bank risks and tight monetary policy may increase bank risks. Interestingly, Thakor (1996), Jiménez et al. (2009) and Martha et al. (2010) document an uncertain effect of monetary policy on bank risks. The interest rate has a smaller impact on the risky assets of the banks with more capital, but a bigger effect on the banks with more business outside statement. Different banks can make the heterogeneous reaction on monetary policy shocks, and banks with high capital adequacy rate and income diversification perform more radical in taking risk.